... Although some of the spinoffs may have targeted underperforming business units, the vast majority of the spinoffs focused on “rising stars” within conglomerates, which when given their corporate independence, significantly outperformed the market....
Introduction
The headlines about Hitachi’s potential divestiture of Hitachi Metals to Bain Capital and CVC Capital Partners’ offer to purchase and take Toshiba private are the most recent in a long line of restructuring efforts aimed at Japan’s mega corporations. The potential Toshiba deal is reminiscent of the numerous leveraged buyouts in the United States during the 1990s, resulting in the breakup of corporate conglomerates into more efficient, capital attracting subunits. See also York Faulkner, Law Firm Opportunities in the Japanese Market, YMF Law Tokyo (2021).
The large “keiretsu” organizations of corporate Japan appear to be natural targets of this breakup and spinoff strategy. And, an obscure provision in Japan’s 2017 Tax Reform Bill may well have opened the door to this new era of corporate restructuring, technology transfer, increased competition for talent, and expanded opportunities for direct investment in emerging businesses.
That provision, which took effect on April 1, 2017, relaxes the tax implications of corporate spinoffs—divesting subsidiaries, divisions, or business units. Before the tax reform, the company spinning off a business typically recognized a capital gain and shareholders were subject to “deemed” dividend taxation. Understandably, those tax consequences had minimized the use of spin offs in corporate restructuring. Now, under certain circumstances, those heavy tax burdens are lifted, and capital gains recognition and deemed dividend taxation can be avoided when spinning off a business. See generally Corporation Tax Act Article 2(xii-11) (defining qualified company spinoff); see also Articles 62-2(3), 62-3, & 62-4 (rules governing succession and transfer of assets at book value).
Corporate Spinoffs Consistently Beat the Market in the United States
The likely economic impact of the increased corporate spin-off activity that flow from these tax savings is both profound and predictable. The leveraged buyouts (“LBOs”) and hostile takeovers that broke up struggling conglomerates, such as RJR Nabisco, after an extended period of economic stagnation during the 1970s and early 1980s are now a legendary part of U.S. history. However, a lesser known part of U.S. corporate history is the extensive voluntary breakup of conglomerates during the 1990s and early 2000s through corporate spinoffs.
During the 1980s, the total value of corporate spinoffs averaged less than $5 billion each year. In 1992, the total value of corporate spinoffs rose to $16.6 billion, and just four years later in 1996, that number had jumped to over $85 billion. During that time, General Motors spun off its information systems subsidiary, EDS. PepsiCo spun off its fast food restaurants, Pizza Hut, Kentucky Fried Chicken, and Taco Bell. And perhaps the largest voluntary breakup at the time was ITT Corporation which fractured into three different companies—ITT Hartford Group (insurance), ITT Industries (automotive, military, and electronics), and ITT Destinations (hotels, gambling, and entertainment).
The spinoff mania was not limited to the United States. During that same period, German Lufthansa spun off its air freight operations, Swiss Sandoz spun off its chemicals business to focus on pharmaceuticals, and France’s Chargeurs split its film and textile divisions into two separate companies. One of the better known European spinoffs at the time was the creation of pharmaceutical giant, Zeneca, which was spun out from Britain’s Imperial Chemical Industries.
Although some of the spinoffs may have targeted underperforming business units, the vast majority of the spinoffs focused on “rising stars” within conglomerates, which when given their corporate independence, significantly outperformed the market. In fact, the results were stunning. In 1995, JP Morgan analyzed the stock-market performance of 77 spinoffs. The research showed that on average, the spinoffs outperformed the stock market by more than 25% during the first 18 months of their independent corporate life. Overall, those gains continued well into the future for most of the spinoffs. Remarkably, the value of the parent corporations grew 20%, on average, over the pre-spinoff value and outperformed the market by 18% during the first year following the spinoff. JP Morgan concluded that “it appears that the remaining slimmer parent company, on average, does materially better than the market following the separation.” (Spinoffs, JP Morgan (1995).)
Spinoffs are Alive & Well in the United States
That spinoff success is not confined to the past. In June 2015, JP Morgan conducted another analysis of spinoffs. As shown in the following chart, although spinoff activity had declined following the Lehman shock, spinoffs are again accelerating and have regained their pre-crisis frequency. In fact, JP Morgan reports that “[t]he pace of separations by S&P 500 firms over the last few years has exceeded the level of any period since 2000.”
JP Morgan identified several factors for the growing number of spinoffs including the availability of capital, increased business line transparency, and increased growth expectations. Investors have become a growing force behind spinoffs, demanding new value-creation and opportunities to invest directly in certain lines of business. Managers likewise are increasingly recognizing that their company’s stock may be trading at a “conglomerate discount” due to investor reluctance to invest in a multi-business organization that lacks transparency as to the performance of its various business units.
Other contemporaneous spinoff activity, including Hilton Worldwide creation of two spinoff companies: (1) Park Hotels and Resorts and (2) Hilton Grand Vacations; Varian Medical Systems’ spinoff of Varex Imaging; BioGen’s creation of BioVerativ; and Hewlett Packard Enterprise Company’s spinoff of DXC Technology.
Other JP Morgan analyses of spinoff outcomes confirm the results of the 1995 analysis about the performance of spinoffs and their parents. As shown in the accompanying chart, the parent companies received a 2%-4% upswing in market value just by announcing a prospective spinoff. During the subsequent two-year period following the spinoff, the combined market value of the parent and spinoff rises on average to about 15%-20%. The data again confirms that both the spinoff company and the parent company share the benefits of a spinoff. According to JP Morgan, the “numbers suggest that the recent wave of separation announcements has the potential to create value of approximately $300 Billion, approximately 2% of the market capitalization of all U.S. firms.” See also Joe Cornell, Spin-Offs Outperforming the Market this Year, Forbes (March 5, 2019) and Spinoffs Roundup: These Companies Could Unlock Value in 2020, AOL News (June 5, 2020).
How Spinoffs Create Value, Economic Growth, & Efficiency
The trend of corporate breakups, demergers, and spinoffs continues in the United States and Europe because spinoffs generate wealth. Board rooms, shareholders, and investors appear to recognize the tremendous value created when more focused, more easily managed, and more specialized enterprises are spun out of larger corporate conglomerates. There are many reasons for the success of spin offs, including management focus, specialization, ease in recruiting outside talent, and access to diverse fundraising sources rather than competing internally for budget allocations from the corporate head office. In many cases, there are substantial benefits to the parent conglomerate as well.
Consider Home Depot’s spinoff of its supply chain division, “HD Supply.” Home Depot is a nationwide do-it-yourself “home center” retail store in The United States. It had a rapidly growing maintenance and construction site delivery service that was managed by its supply chain division. In 2007, Home Depot spun off HD Supply, retaining a minority ownership interest in the company. HD Supply initially raised capital from private equity, and finally made its initial public offering in 2014. In the span of seven years, HD Supply grew from a company with essentially one large customer, Home Depot, to a company with over 500,000 customers and 600 business locations. The success of HD Supply is admirable, but consider the benefits to Home Depot itself from the spinoff. Home Depot’s minority investment in HD Supply has multiplied in value, and Home Depot benefited enormously from the outside investment in HD Supply—effectively using outside investment to increase the efficiency of its own supply chain while divesting the risk of maintaining and supporting a vast supply chain infrastructure.
Spinoffs Will Ignite Japan’s Economy
Against this historical background, there is every reason to suspect that Japan’s 2017 Tax Reform Bill and its relaxed treatment of corporate spinoffs has helped usher in this new era of growth and opportunity. The benefits of spinoffs are not unique to the United States and Europe. There is no reason why the economic value created by U.S. spinoffs cannot also be realized in Japan through the voluntary breakup and reorganization of Japanese conglomerates.
Indeed, spinoffs will do much to solve Japan’s most confounding economic paradoxes. For example, Japan has one of the most educated and capable labor forces in the developed world, yet the data show that Japan’s labor talent is among the bottom in terms of efficient deployment in the economy. During his address to the Japan Summit 2016, Bank of Japan Governor, Haruhiko Kuroda, discussed the technological, globalization, and demographic changes confronting Japan’s economy and said, “Whether Japan’s economy will grow in the long-run depends on whether the country’s labor market can successfully adapt to this changing environment.” (New Challenges for Japan’s Labor Market, Haruhiko Kuroda (Speech at Japan Summit 2016).) Mr. Kuroda noted that “the average number of working years at a specific firm is about 14 years for Japanese male workers, the highest among advanced economies; this compares, for example, with five years for those in the United States and nine years in the United Kingdom.” (Id.)
Mr. Kuroda’s analysis is confirmed by a McKinsey & Co. and LinkedIn study that ranked Japan last in terms of “labor market fluidity” as measured by the number of workers with less than one year of job tenure at their company as a percentage of the total labor force—Japan has only 5% of its workforce with less than one year of job tenure, the United States has 21%, and South Korea has 33%. (A Labor Market that Works: Connecting Talent with Opportunity in the Digital Age, McKinsey Global Institute (June 2015).) Although there are indisputable benefits to the stability of Japan’s labor market, there is increasing evidence that much of Japan’s labor talent is underutilized and trapped within conglomerates. As the data from the McKenzie analysis shows, Japan leads the countries surveyed in the number of professionals who feel that they are overqualified for their jobs—suggesting that their skills could be better matched by changing jobs.
Similarly, by investing roughly 4% of GDP in research and development, Japan continues to be a world leader in technological advancements and the creation of intellectual property. As shown by the accompanying chart, Japanese companies have more than 2.5 million patents in force worldwide. However, other evidence suggests that Japan is not fully reaping the rewards of its investments in technology and intellectual property. In the recent past, many Japanese companies have been actively looking for opportunities to sell off large portions of their patent portfolios—recognizing that the yearly maintenance fees they pay for the patents far exceed the economic value they realize from the patents.
Clearly, Japan does not suffer from either a lack of talent or a lack of technology. Nor is Japan lacking in investment capital. The fundamental problem, as identified by Mr. Kuroda and others, is a persistent and pernicious mismatch of talent, technology, and capital within the Japanese economy.
Indeed, as has been the experience in the United States and Europe, underutilized technology and talent (technical, managerial, and administrative) becomes trapped inside of large organizations—unable to fully realize their full potential value. Moreover, outside investors are unable to invest directly in technologies that are trapped within large conglomerates. As depicted in the accompanying chart, spinoffs solve those fundamental problems.
Managers of the newly independent spinoff company are suddenly free to interact with the outside world in new-found ways—raising capital from a broad base of potential investors, in-licensing complimentary technologies, and recruiting new talent for R&D, marketing, and management. This movement of talent, technology, and capital has obvious beneficial effects on the spinoff itself—increasing the potential for growth and value creation. And when repeated across industries throughout the economy, this increased matching of talent, technology, and capital will have a tremendous positive impact on Japan’s economy overall—moving Japan’s labor and capital markets to greater levels of efficiency, expanding the investment opportunities for Japan’s financial institutions and individual investors, as well as creating new opportunities for Japan’s salaried employees and university graduates.
Comments